Acquisition Drivers Accumulate In a Market Stymied by Uncertainty

Although the broad m&a market remains sluggish, dealmakers say that acquisition drivers are building up in a number of industries. The market downturn has forced many companies to put their acquisition plans on hold. But as economic conditions improve, many analysts think that m&a will pick up in sectors where strategic drivers are compelling and in industries that historically have been hotbeds of merger action but where consolidation hasn’t fully played out. Few experts anticipate a deluge of activity like that of several years ago, but when some degree of certainty and stability returns to the market, they predict that such industries as banking, pharmaceuticals, and building products will lead the m&a rebound. They also expect that divestitures, which contribute significantly to the deal flow, will be robust across all industries this year, as companies aim to deleverage their balance sheets at a time when acquisitions may not be the most workable, or popular, type of deal to execute. Without pointing to any specific sectors, Steven Bernard, director of m&a research at Robert W. Baird & Co., says he expects that the m&a rebound will be led by industries where: * There are products that people understand; * Companies have been able to maintain market share in both good and bad times; * Companies have weathered the economic downturn relatively well; and * Companies still have predictable cash flows and good margins. “These are the characteristics that will attract more capital and as a result will generate more m&a activity,” he says. According to Bob Filek, a transaction services partner at PricewaterhouseCoopers, dealmaking activity will increase in asset-rich industries, such as energy, certain health care sectors, and consumer products. “Deals involving strong assets will be a bit easier to get done because lenders like to lend on assets these days,” he states. Sam Rovit, a director in the Chicago office of Bain & Co., expects to see continued consolidation in fragmented sectors, such as retailing and banking; “timing plays” in industries “where the time to buy is now,” such as industrial equipment; and opportunistic buying, in sectors such as building products. While the experts have some ideas about which industries will lead the m&a rebound, no one could say when the turnaround might occur. Too much uncertainty about the economy and the threat of terrorism and war still cloud the deals market. Yet, when m&a activity begins accelerating, they note, it is likely to happen in the following sectors: Banking – “This year will be the year of the bank merger, on a global basis,” says Graeme Deans, head of the global strategy practice at A.T. Kearney Inc. and chairman of A.T. Kearney Canada. Forces abroad make that very likely. In Germany and France, government state-owned banks are being privatized and encouraged to merge. Japan, whose economy is still floundering, is fertile ground for assets that would be attractive to Western banks, he believes. And countries such as Australia and Canada are gradually relaxing their foreign ownership restrictions on banks, he states. “I think the door might be opened in at least one of those two countries this year for some merger activity,” says Deans. At home, the U.S. banking industry is still fragmented, and robust consolidation among regional banks is highly likely this year, experts say. Having integrated previous acquisitions, buyers are ready to do more deals. Shareholder confidence is on the rise, and Wall Street most likely would give the nod to lower-risk deals backed by sound strategic aims. Industry followers also predict a significant number of sell-offs and purchases of business lines, as players rethink their offerings or stake out competitive advantages. Pharmaceuticals – In an industry where the world’s largest player, Pfizer Inc., has only an 11% global market share, there is still plenty of room for consolidation. Yet, growth by acquisition can be a high-risk strategy, and in the current environment, most drug companies are following a low-risk game plan. Companies do acquisitions to achieve growth aims but they also acquire out of necessity, and experts say that the drivers for drug industry m&a today are compelling. Constantly expiring drug patents and the need for a broader pipeline of strategic-scale products continue to pressure pharmaceutical firms to do deals, says John Maddox, managing director of Infusion Pharma Consulting LLC, a Morristown, N.J.-based strategy consultancy. In this sector, m&a tends to occur in waves, and Johnson & Johnson’s back-to-back acquisitions of 3-Dimensional Pharmaceuticals Inc. and Scios Inc. might be just the spark the industry needs to get players who have been on the sidelines back into the game, he adds. According to Steve Elek, who leads the health care m&a practice at PricewaterhouseCoopers, while drug makers face criticism over increasing drug costs, pharmaceuticals are still the most cost-effective way of reducing health care costs in the U.S. “It is much cheaper for someone to be on a prescription program over the course of a year than to spend a week or two in a hospital. I think that will continue to be a driver of activity in this sector,” he says. Oil and Gas – A new wave of industry mergers is imminent, analysts say. Prices for natural gas and oil have been at, or near, two-year highs recently, which could result in one of the most profitable quarters the sector has ever experienced. Flush with cash, the better-capitalized companies could be in a great position to acquire weaker competitors. “Up-streamers’ E&P units have been disciplined over the last six months. We haven’t seen a lot of m&a, even though commodity prices are at historically high levels both for oil and natural gas. But I don’t the companies can hold back any longer. With natural gas near $6 and oil at nearly $36 a barrel, I’m convinced that CEOs can’t look at these prices and resist doing some m&a,” says Rick Roberge, who leads the oil and gas transaction services group at PricewaterhouseCoopers. Industry sell-offs will also add to the deal flow. Consolidation over the last five years is now resulting in the big oil companies looking to sell significant assets – retail stations, underperforming refineries, and pipeline systems, says Roberge. Large mid-stream companies, under pressure by debt and equity markets to restructure their businesses, also will be selling off assets, he notes. Building Products – As building products manufacturers come off an unprecedented boom in construction activity that lasted about 10 years, some will be looking to cash out and sell while values are high, says Rovit. Jeff Rosenkranz, a managing director and co-head of the middle-market m&a group at U.S. Bancorp Piper Jaffray, adds that when interest rates start to rise, the housing and building products industries may pull back. “But instead of slowing down m&a activity, that might increase dealmaking, because then there might be even more consolidation opportunities because it would force out smaller, less-capitalized competitors.” Automotive Products – Sweeping change that has been reshaping the automotive industry continues to pressure players in all areas of the automotive supply chain. Vehicle manufacturers increasingly are demanding that their suppliers deliver modular components or systems and become systems integrators that can assemble those modules. This requires the Tier 1 suppliers to gain new capabilities. Tiers 1s will continue to look for deals that fill in geographical or product portfolio gaps so that they are in a position to supply modules, says Jeff McKenzie, a managing director at Houlihan Lokey Howard & Zukin. He also expects automotive industry m&a to continue to spill over into additional industries, such as metal processing and metal products. Consumer Products – Despite robust m&a in recent years, industry pros say that the consumer goods sector is almost certain to go through another period of intense consolidation. As retailers continue to consolidate it will become even more difficult for small consumer products companies to survive, says Rosenkranz. With industry giants like Unilever, Nestle SA, and Procter & Gamble Co. dominating supermarket shelves, space for smaller rivals’ products is diminishing. Smaller companies with well-established brands, like H.J. Heinz Co. and Clorox Co., may have to merge with one another to gain scale or avoid being taken over. 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